What Is an Indirect Rollover?
An indirect rollover is a transfer of money from a tax-deferred 401(k) plan to another tax-deferred retirement account. If the rollover is direct, the money is moved directly between accounts without its owner ever touching it. Conversely, with an indirect rollover, the funds are given to the employee directly for deposit into a personal account.
If a person takes a distribution via an indirect rollover, the owner must deposit 100% of the funds into a retirement plan or individual retirement account (IRA) within 60 days to avoid paying income tax and penalties.
- An indirect rollover is the transfer of money from a tax-deferred 401(k) plan to another tax-deferred retirement account in which the funds are paid to the employee directly.
- With an indirect rollover, the full distribution amount must be redeposited into another qualified retirement account within 60 days to avoid income taxes and penalties.
- The direct rollover protects your retirement funds from taxes and penalties since the funds are transferred from the plan administrator to another without the employee handling the funds.
- If not accomplished properly, an indirect rollover can leave you owing income taxes, an early withdrawal penalty, and even an excess contributions tax.
Understanding an Indirect Rollover
A rollover of a retirement account is common when an employee changes jobs or leaves a job to start an independent business. Most of the time, the rollover is direct, in order to eliminate any risk that the individual will lose the tax-deferred status of the account and owe an early withdrawal penalty as well as income taxes.
For example, a direct rollover would be when an employee is due to receive a distribution from a retirement plan and they ask the employer's plan administrator to pay the funds directly to another retirement plan or an IRA on behalf of the employee. In other words, the employee never receives a check or the funds directly with a direct rollover.
However, the account holder does have the option of an indirect rollover, meaning the distribution is paid directly to the account holder. In that case, the employer generally withholds 20% of the amount that is pending transfer in order to pay the taxes due. This money is returned as a tax credit for the year when the rollover process is completed.
60-Day Rollover Rule
An indirect rollover is also called a 60-day rollover since the full distribution amount must be redeposited into a 401(k), individual retirement account (IRA), or another qualified retirement account within 60 days to avoid taxes and penalties.
Once the money is in the hands of the account holder, it can be used for any purpose for the full 60-day grace period. However, if the person then fails to deposit the full amount of the distribution into another retirement account, the amount not redeposited is subject to tax, and a 10% early withdrawal penalty will be imposed if the person is under the age of 59½.
Rollover Amount If Taxes Withheld
It's important to note that even though the distribution will have taxes withheld, you must redeposit the full amount of the distribution within the 60-day window.
For example, let's say that Jamaal—who is under the age of 59½—was paid a $10,000 rollover distribution from his 401(k) plan. Jamaal's employer withheld $2,000 from the distribution, meaning Jamaal received $8,000. If Jamaal decided to roll over the funds into another IRA before the 60-day grace period, Jamaal must redeposit the full $10,000 amount into that retirement account.
If Jamaal rolls over the $8,000 that he received into a retirement account, but not the $2,000 that was withheld, the $2,000 would be considered a distribution subject to income taxes and a 10% penalty. On the other hand, the $8,000 would be considered a nontaxable distribution, and no taxes and penalties would be owed.
To avoid taxes and penalties, Jamaal would need to redeposit the full $10,000 distribution amount within 60 days, meaning he would need to come up with $2,000 from other sources.
The indirect rollover process must be completed within 60 days if a big tax bill and a tax penalty are to be avoided.
Why Use an Indirect Rollover?
Personal financial advisors and tax advisors pretty much unanimously advise their clients to always use the direct rollover option, not the indirect rollover.
The only reason to use the indirect rollover is if the account holder has some urgent use for the money, and it can be accomplished without risk within 60 days. For example, someone relocating for a new job may have large immediate expenses that will be reimbursed in time. Failing to meet the 60-day deadline is a common mistake made by IRA account holders.
Other Requirements With Indirect Rollovers
Whether there's a good reason for using the indirect option or not, the Internal Revenue Service (IRS) has some pretty picky rules that could trip up the account holder:
- Only one indirect rollover is permitted within a 12-month period. (That means any 12-month period, not a tax year.)
- The transfer must be from one account to another account and cannot be split among multiple accounts. If the funds are split into two accounts, the IRS will consider it two indirect rollovers.
Mess up either of these rules, and you're on the hook for income tax for the entire amount withdrawn, plus the 10% early distribution tax. Also, splitting the money between accounts as described above has an added penalty of its own, where you'll also owe a 6% excess contribution tax on one of the two accounts every year for as long as the account exists.